Great article from the WSJ on subprime mortgages

Subprime mortgages are loans made to borrowers who are considered to be higher credit risks because of past payment problems, high debt relative to income or other factors. Lenders typically charge them higher interest rates — as much as four percentage points more than more-credit-worthy borrowers pay — one reason subprime mortgages are among the most profitable segments of the industry.

They also have been among the fastest-growing segments. Subprime mortgage originations climbed to $625 billion in 2005 from $120 billion in 2001, according to Inside Mortgage Finance, a trade publication. Like other types of mortgages, subprime home loans are often packaged into securities and sold to investors, helping lenders limit their risks.

Until the past year or so, delinquency rates were low by historical standards, thanks to low interest rates and rising home prices, which made it easy for borrowers to refinance or sell their homes if they ran into trouble. But as the housing market peaked and loan volume leveled off, some lenders responded by relaxing their lending standards. Now, the downside of that strategy is becoming more apparent.

Based on current performance, 2006 is on track to be one of the worst ever for subprime loans, according to UBS AG. “We are a bit surprised by how fast this has unraveled,” says Thomas Zimmerman, head of asset-backed securities research at UBS. Roughly 80,000 subprime borrowers who took out mortgages packaged into securities this year are behind on their payments, the bank says.

So how many losses?

Predicting losses on these securities is a challenge because there’s little or no historical evidence to show how subprime loans will perform at a time when home prices are falling, says Thomas Lawler, a housing economist in Vienna, Va. An analysis by Merrill Lynch & Co. found that losses on recent subprime deals could be “in the 6% to 8% range” if home prices are flat next year and could rise to the “double digits” if home prices fall by 5%. Falling home prices could trigger losses not only for investors who bought riskier classes of mortgage-backed securities, but also for some holders of A-rated bonds, according to the report.